Economic Update
21st June 2010
The Chinese revaluation
Contacts:
Madan Sabnavis
Chief Economist
91-022-67543489
Samruddha Paradkar
Associate Economist
91-022-67543407
Krithika Subramanian
Associate Economist
91-022-67543321
The Chinese central bank announced on Saturday night that it
would increase the flexibility of its exchange rate, an indication that
it will resume a policy of gradual appreciation of the renminbi
against the dollar after nearly two years, when the rate has
remained unchanged. However, it has been careful with its wording
of its approach to the exchange rate.
The central bank statement suggests that shifts in the exchange
rate are likely to be slow, which could result in continued
international criticism that the renminbi is still artificially low. The
People’s Bank of China said there was no basis for a large-scale
appreciation, given the sharp drop in China’s current account
surplus over the last year, and that the current trading bands for
the currency would remain in place.
When Beijing lifted its currency peg in July 2005, it allowed the
renminbi to appreciate against the dollar over three years to mid2008 when the peg was reinstated. Beijing could again allow a
similar pace of appreciation. But it could go much slower. China
remains nervous about Europe’s debt crisis and divided over the
wisdom of giving up export competitiveness.
This move, if implemented would strengthen Asian currencies in
particular. An appreciation of the renminbi would make imports
cheaper for the domestic consumers who demand more imported
goods – especially capital goods. Countries whose growth is linked
with China would tend to gain.
But, a lot depends on the extent to which the Chinese central bank
appreciates the currency. It may not mean much, according to
critics who feel that this move has been done strategically before
the G20 conference, where this issue was to come up for
discussion.
ECONOMIC UPDATE
The movement in the renminbi so far
$-Renminbi: Jan 2005 to May 2010
8.5
Renminbi/$
8
7.5
7
Apr-10
Jan-10
Oct-09
Jul-09
Apr-09
Jan-09
Oct-08
Jul-08
Apr-08
Jan-08
Oct-07
Jul-07
Apr-07
Jan-07
Oct-06
Jul-06
Apr-06
Jan-06
Oct-05
Jul-05
Apr-05
6
Jan-05
6.5
China had a virtual pegged exchange rate until June 2005, when it had agreed to correct the
currency in light of the current account surplus. The correction via an appreciation was on till midJuly when China reverted to a virtual pegged currency. The renminbi had strengthened from an
average of 8.28/$ in June 2005 to 6.84/$ by July 2008 – an appreciation of 17.4% over 3 years. It
has remained at this level subsequently.
Chinese action
The Chinese central bank, PBOC (People’s Bank of China) announced on Saturday that it would
increase the flexibility of the exchange rate and that it would be maintained at a ‘stable and
adaptive equilibrium level’. It will further effectively abandon its currency peg with the US dollar.
The central bank said that the dollar peg had served a role when the international crisis “was at
its worst” but that the “the global economy is gradually recovering” and the rebound in the
Chinese economy was more “solid”. The PBOC said it will be guided by a “basket” of currencies,
not the dollar alone. If the euro resumes its slide in the next few weeks or months, the renminbi
(Yuan) might even be nudged down a bit against the dollar, to keep its trade-weighted value
stable.
It has also pointed to the sharp drop in the country’s current account surplus as evidence that
substantial rebalancing of the economy is already taking place. The current-account surplus has
narrowed over recent years, from 11% of GDP in 2007 to 6.1% of GDP last year. There was
therefore no justification for a “large-scale appreciation” of the exchange rate
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ECONOMIC UPDATE
Why has China changed its mind?
The PBOC (People’s Bank of China) insists that the decision was taken for domestic reasons.
However, critics aver that this announcement comes a week ahead of a G20 summit in Canada
that was shaping up to be something of a showdown over the level of the Chinese currency.
China’s announcement that it will introduce more flexibility into its exchange rate is a deft political
move amid rising international criticism of Beijing, but the economic implications are much less
certain.
Likely scenarios
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-
-
-
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China’s exchange rate against the euro has already appreciated 15% in recent months,
raising worries about slowing exports to China’s biggest market. This being the case
China would be more circumspect on the appreciation of its currency. Besides, inflation in
China is higher than most of its trading partners, meaning that China’s real exchange rate
is also rising.
Dealers and analysts expect appreciation against the US dollar in the short term of 0.2%
a month – well short of the likely level needed to appease critics.
The use of the phrase greater “flexibility” in the exchange rate could potentially include
occasional periods of depreciation against the dollar. By stressing that the renminbi will
be managed against a basket of currencies, they have an excuse to weaken the currency
against the dollar and punish speculators if the euro continues to depreciate.
Some analysts feel that the PBOC will first allow the renminbi to change only marginally
and when it is confident that China’s economic momentum can survive the euro-area’s
woes, it will let the Yuan strengthen at about the same pace as before the crisis, i.e.
about 5% a year, on a trade-weighted, inflation-adjusted basis.
An appreciation will automatically increase the purchasing power of both China’s
corporates and households. History has shown that even a gentle pace of Yuan
appreciation is a powerful tonic for economies and assets that are leveraged on Chinese
growth. In particular capital goods exporters of Asia such as Japan, South Korea and
Taiwan and the world’s bulk commodity exporters like Australia and Brazil are the key
beneficiaries of China’s current growth model. In fact both Australia and Korea have
shown a very strong correlation with China and hence both currencies and stocks are
expected to receive a boost from this move.
Economists also hope a higher Yuan could help temper inflation in China by pushing
down import prices, which in turn could mean Beijing would have less need to tighten
monetary policy aggressively. Markets had been worried that China could over-tighten
and suffer a hard landing.
The big question mark?
The issue really is as to by how much will the renminbi appreciate or rather correct? The extent of
correction will guide the movement of trade flows. It was believed that the Yuan was undervalued
by as much as 25% giving it an advantage. The Yuan rose as high as 6.8110 per dollar on
Monday, the 21st June up just 0.2 percent from its close on Friday of 6.8262, but still the highest
level since September 2008. It was also the biggest intraday rise since October 2008, further
evidence that the central bank was allowing the currency some room to move more freely. The
central bank sets a daily reference point each day for Yuan trade. The currency is allowed to
move 0.5 percent either side of the reference point. The central bank earlier set the reference
point at 6.8275 per dollar, unchanged from its reference point on Friday, prompting some doubts
about China's intentions and a slight cooling in the rally in other markets.
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ECONOMIC UPDATE
Implications for India
For the period January 2005 to May 2010, the coefficient of correlation between the Rs/$ and
REM/$ rates was -0.32. This was however, skewed due to the static REM/$ for the period
subsequent to July 2008. However, for the 3 year period between June 2005 and June 2008 the
coefficient of correlation was 0.69 (and significant), meaning thereby that further appreciation of
the Yuan would be associated with the rupee also strengthening under ceteris paribus conditions.
India’s trade per se with China is significant with China accounting for 10.4% of our imports in
FY2009 and 4.9% of our exports being directed to China.
--------------------------------------------------------------------------------------------------------------------------------Disclaimer
The Report is prepared by the Economics Division of CARE Limited. The Report is meant for providing an analytical view
on the subject and is not a recommendation made by CARE. The information is obtained from sources considered to be
reliable and CARE does not guarantee the accuracy of such information and is not responsible for any decision taken
based on this Report.
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